In hard times, firms tend to offer precarious temporary contracts rather than safer, long-term contracts. In light of this, this column looks at reforming employment protection. Overall, the debate amongst economists focuses far too much on the convergence of these two types of contracts. Policymakers would do well to begin looking at other, more attractive and more implementable options.

Dualism – the division of the labour market between highly paid primary workers in stable jobs and secondary workers in low paying precarious positions – has remained at the forefront of public debates in Europe, where it is pervasive. Between 1985 and 2008, European countries (with the exception of Denmark) experienced an increase in the share of temporary contracts (12% on average in OECD countries): it was particularly high in Spain (24.9% in 2010, from Eurostat) and in the Netherlands (18.5% in 2010, from Eurostat).

This led to several labour-market reforms in the 1980s and 1990s. France, Germany and Spain focused their efforts on limiting the use of fixed-term contracts whereas the UK, Italy, Denmark and Finland moved towards more flexible employment protection regulations. The main culprit for dualism is employment protection, which limits employers in their termination decisions: faced with a change in the economic trend, they are likely to bear important costs if they decide to fire workers. This creates an incentive for employers to offer temporary contracts instead. More recently (since 2005), several new experiments inspired by the logic of a single employment contract have been conducted with the explicit goal of addressing the negative consequences of dualism. These reforms however had mixed political success.1

Single employment contracts

Generally speaking there are two forms of single employment contracts: contracts with Progressive Seniority Rights and contracts with Long Probationary Periods. Any combination of these two forms is possible. An important question is whether the political costs of a single contract would dominate over the benefits of such a reform.

New research on reforming employment protection

In recent research, we argue here that the single contract would not eliminate the consequences of dualism and could increase unemployment if not accompanied with a drastic reform of employment protection (Lepage-Saucier, Schleich and Wasmer 2013). Therefore we believe that the debates focused on the implementation of a single employment contract deviate from the real issue: the reform of employment protection.

The single employment contract is presented as a tool to reduce inequalities caused by dualism. Indeed, having two distinct forms of employment makes duality visible in the labour market. It also gives employers landlords or banks legal means to discriminate between different groups of workers. While temporary workers face job insecurity, workers under permanent contracts are highly protected in case of dismissals and therefore are more likely to have stable careers.

Access to credit and training

Cahuc and Kramarz (2004) argue that at the age of 30, permanent workers are 10 to 15 percentage points more likely to become home-owners because they benefit from an easier access to credit. Banks are less willing to grant loans to temporary workers, viewed as economically unstable. This makes it more difficult for them to buy a house. Introducing a single employment contract with a long probationary period, in this context, is likely to be inefficient: workers under probation or facing low seniority rights would still be discriminated against and the gap between workers would remain. Moreover, alternative reforms such as a partial deregulation of the rental housing market may be more effective.

Another consequence of the gap between temporary and permanent workers is the inequality in the access to training. Firms invest in training if it provides workers with skills that are profitable: as a consequence, permanent workers are more likely to receive training than others. Yet again, workers under probation or with low seniority rights are likely to face an unequal access to training. However, more efficient solutions to avoid this unequal treatment exist: for instance, Lemoine and Wasmer (2010) proposed to introduce specific Pigouvian incentives for French firms by reducing their taxes or layoffs costs should they train more workers. The goal is to internalise the positive externality created by general training, using a similar logic to Blanchard and Tirole’s experience rating system.

Stigma effects for laid-off workers under a single contract

Temporary contracts may stigmatise workers. Indeed, due to the difficulty employers find when trying to dismiss their workers under a regular contract, employers use temporary employment as a screening device. Workers whose contracts have not been renewed are not necessarily presumed to be less motivated or less skilful: a bad economic situation could have reduced the incentive of offering regular contracts. The termination of a worker under a Contract with Progressive Seniority Rights or with Long Probationary Periods would however reinforce the negative signal on the worker since it could only be due to the workers’ lack of skill or motivation, not to the firms’ characteristics or to the formal impossibility to renew the contract. A single contract with a long probationary period may also reinforce abuse: probationary periods, which are less regulated than the current temporary contracts, could be used in the same way while protecting the workers less, since, in most countries, terminating a temporary contract is prohibited.

A single contract may reduce the volatility of employment

The cost difference in terms of dismissal requirements between temporary and permanent contracts leads firms to use temporary contracts as an adjustment variable to the economic conjuncture: in periods of economic booms, the high costs linked to permanent contracts lead firms to use temporary contracts (subject to weak regulations) when they seek to hire new employees. In periods of crises, the existing regulations force firms to respond to economic fluctuations through labour turnover instead of using alternative methods such as changing the workplace organisation. This results in excessive turnover in the labour market (more hires in temporary contracts but also more terminations).

To confirm this intuition, we built a model with heterogeneous anticipations on workers’ productivity and two possible types of contracts (temporary contracts are used to screen for more productive workers). Our results show that uncertainty on productivity is a key element in the decision to hire more temporary contracts.

However, simply eliminating temporary contracts reduces employment

Our model also shows that without a drastic reform of employment protection, eliminating temporary contracts reduces employment: heterogeneity in the labour market discourages firms from taking risks with workers that are perceived as having a lower productivity. The analysis summarised in Figure 1 gives the following conclusions:

For a constant level of employment protection of regular contracts, removing temporary contracts leads to a drop in employment that may be as high as seven percentage points.

Reducing employment protection raises employment; this improvement is more important in the absence of temporary contracts.

Without temporary contracts, the level of employment reached when both permanent and temporary contracts coexist can only be restored if the layoffs costs of permanent contracts are drastically reduced, namely to a third of their initial value.

Figure 1. the effect of employment protection (F, as a fraction of yearly productivity) on employment in a dual economy and in an economy with only regular contracts.

The problem arises not from dualism as such but rather from the costs of employment termination. Beyond these aspects, in many countries the legal prerequisites behind ‘economic layoffs’ create uncertainty. Paradoxically, countries in which they are the strongest are also those where employees perceive their job to be the less secure and suffer the most from stress. Economic layoffs may lead firms to put more pressure on their workers to increase productivity or to obtain dismissals at lower costs.

Finally, employment protection is also known to have negative effects on the allocation of productive units: it can favour less productive structures and slow the allocation process of workers on the most productive activities, creating distortion of capital accumulation.

Conclusion

A large part of the debate on how to favour employment and reduce dualism focuses on the implementation of a single employment contract. It is a way of arguing for the convergence of different types of labour contracts which, at first hand, seems like the least costly solution. However, advocates for the single labour contract have conflicting views and disagree on its characteristics. The 'single labour contract' is meant to be a quid pro quo (an exchange of something against something else, understood by all parties). By single labour contract, proponents of this measure probably mean ambitious reform of permanent contracts through a reduction of employment protection. This part may however be a qui pro quo (a misunderstanding due to voluntary ambiguity on the concepts) if it results in the disappearance of temporary contracts and the implementation of an extended probationary period. Moreover, Unions are unlikely to favour this solution since fixed term contracts are fairly well protected and could only be replaced by options which offer less security to the workers, such as longer probationary periods, or an increase of individual layoffs for insufficient skills even for permanent contracts.

The focus on the convergence of contracts undermines alternative and more transparent reforms of the labour market such as the so-called ‘flexi-security model’ which argues for a to a reduction in layoff costs in exchange for a more generous unemployment insurance and more efficient active labour market policies including training reforms.

Editor’s note: This column is the summary of an extended analysis: Moving towards a single contract? Pros, cons and mixed feelings, OECD Economics Department Working Paper 1026, Feb. 2013, by the three authors, and of LIEPP policy brief No. 8.

1 Recent reforms include the 2005 “Contrat Nouvelle Embauche” in France, abandoned due to legal imperatives (it was contrary to International Employment Convention n°158); the 2012 Italian reform, meant to simplify its labour code by reducing the number of contract types, but whose ambitions were substantially reduced after debates in Parliament; and the introduction of a new open-ended contract for small companies introduced in 2012 in Spain.